The "term structure" of interest rates refers to the relationship
between bonds of different terms. When interest rates of bonds are plotted
against their terms, this is called the "yield curve". Economists and
investors believe that the shape of the yield curve reflects the market's future
expectation for interest rates and the conditions for monetary policy.
Usually, longer term interest rates are higher than shorter term interest
rates. This is called a "normal yield curve" and is thought to reflect
the higher "inflation-risk premium" that investors demand for longer
term bonds. When interest rates change by the same amount for bonds of all
terms, this is called a "parallel shift" in the yield curve since the
shape of the yield curve stays the same, although interest rates are higher or
lower "across the curve". A change in the shape of the yield curve is
called a "twist" and means that interest rates for bonds of some terms
change differently than bond of other terms.
A small or negligible difference between short and long term interest rates
occurs later in the economic cycle when interest rates increase due to higher
inflation expectations and tighter monetary policy. This is called a "shallow"
or "flat" yield curve and higher short term rates reflect less
available money, as monetary policy is tightened, and higher inflation later in
the economic cycle.
When the difference between long and short term interest rates is large,
the yield curve is said to be "steep". This is thought to reflect a "loose"
monetary policy which means credit and money is readily available in an economy.
This situation usually develops early in the economic cycle when a country's
monetary authorities are trying to stimulate the economy after a recession or
slowdown in economic growth. The low short term interest rates reflect the easy
availability of money and low or declining inflation. Higher longer term
interest rates reflect investors' fears of future inflation, recognizing that
future monetary policy and economic conditions could be much different.
Tight monetary policy results in short term interest rates being higher than
longer term rates. This occurs as a shortage of money and credit drives up the
cost of short term capital. Longer term rates stay lower, as investors see an
eventual loosening of monetary policy and declining inflation. This increases
the demand for long term bonds which lock in the higher long term rates.
Economists and financial academics have developed theories to explain the
shape of the yield curve. The "expectations" theory states that
sinces short term bonds can be combined for the same time period as a longer
term bond, the total interest earned should be equivalent, given the efficiency
of the market and the chance for arbitrage (speculators using opportunities to
make money). Mathematically, the yield curve can then be used to predict
interest rates at future dates.
The "segmentation" theory explains the shape of the yield curve by
investors' term preferences. Some investors need to deploy their funds for
specific periods of time, hence a preference for long or short term bonds which
is reflected in the shape of the yield curve. An inverted curve can then be
seen to reflect a definite investor preference for longer term bonds.
With powerful computers and mathematical techniques, investors and academics
are constantly striving to build models which explain the shape of the yield
curve and hopefully provide insight into the future direction of interest
rates. This has given rise to "yield curve" strategies which are
employed by bond managers to add value to their portfolios. |